Only the Strong Shall Thrive

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As the financial markets squealed in pain last August and frozen leveraged-buyout deals had bankers pulling their hair out, health-care distributor Henry Schein was in a different frame of mind. It was extending a $57 million offer to acquire the shares of New Zealand–based Software of Excellence, a developer of practice management systems for dentists.

Not that Henry Schein’s executives didn’t worry about the spreading subprime-debt fiasco. A credit crunch, billions in stuck deals, and an eerily uncertain situation provided plenty of cause for concern. But fear was not the overriding theme at Henry Schein’s Melville, New York, headquarters. In fact, if one clear message emerged, it was that this was a good time for the $5 billion company to step up its acquisitions.

“For companies like ours that are in a strong cash position and have financing in place, this [credit crunch] is an advantage,” says Steven Paladino, CFO of Henry Schein, which has $200 million in cash as well as an untapped line of credit. “We can do transactions without a financing contingency.”

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Not all companies are as fortunate as Henry Schein. A five-year stretch of plentiful and cheap borrowing is over, the subprime-mortgage meltdown having ushered in a new reality. Banks have tightened lending, borrowing costs have risen, and tolerance for risk has fallen off a cliff. Besides putting a number of mortgage lenders out of business and virtually shutting down the LBO pipeline, the crunch is altering the financing landscape for all companies going forward.

In many ways, the turmoil is self-inflicted — overissuance of leveraged paper to feed the LBO machine combined with overissuance of subprime mortgages to feed Wall Street’s securitization engines. Record underwriting in both categories the past few years resulted in looser lending standards and removal of covenants. The system hummed until June, when investors balked and demanded higher payment for risk.

Assuming no further deterioration in the economy, the effects should be painful but not catastrophic, limited to what Wall Street calls the elimination of froth and the return of reason. But if economic conditions deteriorate, then everything from moderate pain to a full-blown recession is on the table. “The biggest risk is the economy,” says Mike Jackson, segment leader of the corporate banking group at KeyBanc Capital Markets. “If the economy turns and you start to see true defaults, that will cause a natural tightening to the credit cycle.”

For now, it is companies with leveraged-up balance sheets that are feeling the squeeze. For them, debt has become pricier and more scarce. And those planning a payday through a sale to private-equity players may not see that day anytime soon. But solid credits with strong banking relationships should be able to finance without a problem, Jackson says. In fact, some can find opportunities in crisis, in the form of cheaper acquisitions and weakened competitors.

The Return of Risk

The sharpening difference between stronger and weaker credits has to do with the way investors view risk. Before the credit turmoil, a combination of low interest rates, plentiful liquidity, a strong economy, and a hot real estate market took the edge off risk, making funding easily available to issuers, including speculative-grade companies. Leveraged loans, which weaker companies use to raise capital, exploded, hitting a record $427 billion in the first half of 2007, a 42 percent increase over 2006, according to Fitch Ratings.

Credit spreads narrowed on lower-grade securities as credit eased, meaning that investors were willing to accept little reward for taking extra risk. For example, spreads on high-yield corporate bonds, which were 818 basis points in March 2003, narrowed to 282 basis points in early 2007, according to the Securities Industry and Financial Markets Association. During the same period, spreads on subprime mortgages also shrank. As long as real estate prices kept rising, all was well.

But as real estate prices began to fall and subprime-mortgage defaults rose in late 2006 and early 2007, securitized bonds containing subprime mortgages collapsed, shaking investor confidence. By summer, investors were rejecting low-yielding, risky debt that carried lax issuance standards, including around $350 billion in leveraged financing, mostly for LBOs, basically shutting down the deal machine. As the market struggles to regain its footing, yields for lower-grade investments are climbing as investors demand more pay for risk. That trend is expected to continue. “As much as we thought it was different this time, it was not — there will be a reassessment of risk,” says Art Hogan, director of global equity product at Jefferies & Co.

Rising interest on high-yield debt endangers highly leveraged firms. Businesses with lower credit ratings tapping the high-yield bond market are paying an average of 2 percent more than they did in early summer, according to Fitch. Spreads have widened to 456 basis points over 10-year Treasury notes as of early September, versus 240 basis points in early June.

Higher interest rates make it more difficult for speculative-grade corporations to refinance by issuing new debt. This could well kick off a wave of defaults and bankruptcies. Edward Altman, director of the credit-and-debt-markets program at New York University’s Salomon Center, Stern School of Business, says high-yield debt issuers typically begin defaulting in the second year after issuance, and nonperformance accelerates in the third and fourth years. That scenario doesn’t take into account outside conditions such as the economy and liquidity, he says. High liquidity, for example, can keep such companies propped up, as it did during the credit bubble, but with credit tighter, more bankruptcies are likely, Altman says.

Moody’s predicts that the speculative-grade corporate default rate will rise from about 1.5 percent to 4.1 percent in the coming year. And the number could climb to 5.1 percent by August 2009.

Bankruptcy rates are rising, too. The American Bankruptcy Institute reports a 45 percent surge in business bankruptcies in the first half of 2007 from the same time in 2006. But the 12,985 business filings of the first half are still historically low, about 30 percent down from the comparable period in 2004.

Waiting for Distress

Distressed-debt and other investors are ready. “We have been waiting for this,” says Philip Von Burg, principal of New York–based Monomoy Capital Partners, which invests in financially underperforming firms. Von Burg expects marginally higher financing costs, but because his firm has a conservative approach to debt, he believes bank funding will still be obtainable.

So far, the companies most hurt by banks’ tightening have been those connected to housing, like Irvine, California-based Standard Pacific Corp., a home builder that also provides mortgage financing. In late August, the company took steps to avoid defaulting on a tangible net worth covenant it had with its lenders. It entered negotiations with its banks to reduce its credit facilities and renegotiate its leverage ratio. In a Securities and Exchange Commission filing, the company said it planned to reduce a revolver to $900 million, from $1.1 billion, and cut a term loan to $225 million from $250 million.

Renegotiation may have its limits in this market. “We expect Standard Pacific will violate its tangible net worth covenant (it must stay above $1.37 billion) in the second half of 2007,” wrote Banc of America Securities analyst Daniel Oppenheim. “We believe lenders remain flexible on renegotiating covenants for now, but see risk as conditions deteriorate further.” Smelling opportunity, hedge fund Citadel LP acquired a 4.9 percent stake in Standard Pacific in August.

Not everyone is convinced the roof is about to cave in. Brian Ranson, managing director of credit strategies at Moody’s K.M.V., which tracks corporate default risk, says that aside from the real estate sector, many companies remain in good shape. “We measure the default risk of tens of thousands of companies,” he said in late August. “What we observe is that the strength of Corporate America is not affected by subprime [issues].”

Cash Is King — Again

Indeed, while credit costs are rising and leverage ratios are tightening for speculative-grade issuers, other companies are in pristine condition. “We spent the past few years preparing ourselves for just this type of market,” says David Johnson, CFO of The Hartford Financial Group. “The time you want to have liquidity and capital is when other people don’t.” The Hartford has increased its credit facility to $2 billion from $1.6 billion and extended its maturity. Luckily, it began negotiating with its banks in the spring and managed to close the amended facility on August 9.

To build another layer of protection, The Hartford also entered into a funded $500 million contingent capital facility that can be tapped “on a rainy day” in the future. While he would like to believe his firm could get the same terms even in the middle of the credit crisis, Johnson is not certain.

Like The Hartford, many companies have been accumulating cash. A survey last May by the Association for Financial Professionals found that 36 percent of companies responding held more cash and short-term equivalents than 6 months earlier. (Eighteen percent decreased balances; the rest saw no change.) Moreover, 27 percent expected to add to their cash balances in the ensuing 12 months. Most stashed funds in money-market funds, bank deposits, and commercial paper.

What is The Hartford doing with its excess cash? Johnson says current conditions may well present a stock-buyback opportunity. The firm’s share price was only 5 percent above its 52-week low in early September. It has a $2 billion authorization, of which it has already purchased $250 million worth of shares. Indeed, S&P 500 companies spent a record $158 billion in the second quarter on stock buybacks, the seventh consecutive quarter of more than $100 billion in such spending.

Companies have been hoarding those repurchased shares in Treasuries without retiring them, says Howard Silverblatt, senior index analyst at Standard & Poor’s. One way to use them, he says, would be for acquisitions.

For strategic buyers, this is a good time to shop. M&A volumes are already down from the record $2.65 trillion of the first half of 2007 and premiums are lower. In the days of extreme liquidity, private-equity buyers drove up prices, often snatching deals from strategic buyers. “Private-equity buyers were able to raise their bids because they were able to borrow so much — seven times cash flow plus 25 percent in equity,” says Steve Bernard, director of M&A market analysis at R.W. Baird & Co. “It has probably come down to four or five times cash flow.”

There is plenty of strength in small and midsize deals, one reason being that the middle market tends to finance more conservatively and is not as reliant on high-yield issuance.

Deals typically consist of 25 to 35 percent equity with the balance made up of senior secured debt and, in recent years, a layer of partially secured junior debt. The use of junior debt will diminish as it becomes more expensive due to investors demanding a higher rate of return, says Monomoy’s Von Burg.

But midmarket deals have not been immune to market conditions already, as banks often renegotiate the terms before closing. “Fifteen months ago people would be lined up to help you,” says Dan Reid, head of transaction advisory services at Grant Thornton. To bridge the gap, buyers and sellers will have to negotiate a lot more, he says. Solutions may include buyers putting in more equity or sellers holding part of the debt.

For the overall financing and M&A pipelines to flow again, and for the leveraged finance market to open up, deals will have to be renegotiated for the new risk reality. As of early September, appetite for high-yield securities in their bubble format was nonexistent. Banks have been busy trying to renegotiate terms with private-equity buyers and make the securities more appetizing to investors — raising yields and adding covenants to bolster investor protection. Unless restructured, these deals would fetch below-par pricing, making it uneconomical for banks to underwrite them in their present form.

That is a big departure from the height of the bubble, when banks “were able to sell these [leveraged loans used for acquisitions] after the deals closed for more than 100 cents on the dollar,” says Gary Rosenbaum, head of the finance group at DLA Piper. Home Depot, for example, had to slash $2 billion from the price of its wholesale unit in August (to $8.3 billion) in order to make the deal possible. Rosenbaum expects a lot more of that.

“There will be a lot of preparation and adjustment to financings to make them palatable,” says Mark Howard, co-head of research at Barclays Capital.

Absent an economic slowdown, which could tighten debt even more, market participants expect a return to reason rather than to a restrictive market. They also foresee a lower profile for private equity and a higher profile for strategic buyers. “Investment-grade companies will have a good and normalized access to capital in the corporate bond, commercial-paper, and loan markets,” says Howard. “Higher-yielding companies will also have access, but at a wider spread and slightly more nervous covenants.”

Avital Louria Hahn is a senior editor at CFO.

Financing’s New Language

Dealmaking language is changing, signaling less freedom for issuers and more protection for investors and banks. Gone are dividend recaps, refinancing, covenant-light deals, second-lien loans, and payment-in-kind (PIK). Back in the lexicon are market clauses, covenants, earnouts, and sellers’ notes.

The return of vigilance is evident in the commitment letters banks give buyers to finance acquisitions. During the buyout frenzy, private-equity buyers often committed to purchasing companies without financing contingencies (like buying a house without the assurance you will be approved for a mortgage). In turn, private-equity firms pressed banks for firm financing commitments. Banks issued commitment letters without strong escape clauses and, as a result, were stuck with billions in debt they were unable to unload. Banks are now inserting tighter terms, including market clauses, which give them an out if market conditions worsen.

Covenants, once a staple, were removed in the frenzy, hence covenant-light deals. Omitting these agreements, which protect investors, enabled issuers to sell debt without obligating them to meet performance benchmarks. Covenant-light deals are now gone and traditional covenants are back. Also gone are PIK clauses. These toggle-like features enabled issuers to pay investors in bonds instead of cash at their choosing.

Financial buyers will also have to do without dividend recaps, which allowed buyers to reap a windfall long before exiting an investment by loading companies with extra debt. (Think Hertz and the $1 billion in additional debt that Clayton, Dubilier & Rice Inc., Merrill Lynch, and The Carlyle Group paid themselves just six months after acquiring the company in September 2005.) Ditto for refinancing. With debt tighter, companies on the edge may not be able to refinance with new cheap debt and instead may have to be sold. Gone too is unsecured debt such as second-lien loans.

With banks retrenching, buyers and sellers in M&A deals can expect more negotiations about bridging financing gaps. Helping close such gaps are earnouts and sellers’ notes. Earnouts are benchmarks a company has to meet after it is sold, while sellers’ notes mean a seller agrees to hold part of the debt. For example, to complete the sale of its wholesale unit in August, Home Depot had to agree to finance $1 billion of the deal price. — A.L.H.